How to Calculate WACC (Weighted Average Cost of Capital)

The Weighted Average Cost of Capital (WACC) is the rate a company is expected to pay to finance its assets. It represents the minimum return a business must earn to satisfy both debt and equity investors.

The WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1 − Tc))

Where:

• E = Market value of equity
• D = Market value of debt
• V = E + D (total firm value)
• Re = Cost of equity
• Rd = Cost of debt (pre-tax)
• Tc = Corporate tax rate

Step-by-Step Calculation

Step 1: Find the Capital Structure

A company has:

• Equity: £600 million (market cap)
• Debt: £400 million (market value of bonds)
• Total: £1,000 million
• E/V = 60%, D/V = 40%

Step 2: Cost of Equity (Re)

Use the Capital Asset Pricing Model (CAPM):

Re = Rf + β × (Rm − Rf)

• Rf = Risk-free rate (e.g. UK gilt yield = 4.2%)
• β = Beta (e.g. 1.3)
• Rm − Rf = Market risk premium (e.g. 5%)

Re = 4.2% + 1.3 × 5% = 4.2% + 6.5% = 10.7%

Step 3: Cost of Debt (Rd)

The pre-tax yield on the company's debt, e.g. 5.5%.

Step 4: Apply Tax Shield

Interest is tax-deductible, so the effective cost of debt is lower:

After-tax cost of debt = 5.5% × (1 − 0.25) = 4.125%

(Assuming 25% corporate tax rate)

Step 5: Calculate WACC

WACC = (60% × 10.7%) + (40% × 4.125%)
WACC = 6.42% + 1.65% = 8.07%

What WACC Is Used For

• Discounted Cash Flow (DCF) valuation — WACC is the discount rate
• Investment decisions — projects must return more than WACC to add value
• Capital structure optimisation — finding the debt/equity mix that minimises WACC

Sensitivity Table

Limitations of WACC

• Assumes constant capital structure over time
• CAPM has its own assumptions (linear risk relationship, efficient markets)
• Hard to apply to private companies without a quoted beta
• Does not account for asymmetric information between debt and equity holders